What Is an Inverted Spread?
An inverted spread is a situation in which the yield difference between a longer-term financial instrument and a shorter-term instrument is negative. This spread is calculated by subtracting the longer term from the shorter term. In effect, the shorter-term instrument is yielding a higher rate of return than the longer-term instrument. This is in contrast to a normal market, where longer-term instruments should yield higher returns to compensate for time.
Understanding Inverted Spread
An inverted spread is considered an abnormal scenario, and it is also a phenomenon that most investors would find undesirable. Investors assume shorter-term instruments will have a lower yield. By contrast, investors expect a higher yield if their money will be tied up for a longer period of time. This higher yield is considered the payoff the investor gets in return for committing their initial outlay of resources for this extended period of time.
A spread that is trending in an inverted direction can sometimes be a red flag that indicates investor confidence in the short-term outlook has plummeted. Investors in this mood will feel more comfortable with the prospect of longer-term instruments. In this environment, investors may be less anxious to invest in short term securities, and issuers must offer a higher yield as a way to attract investors and motivate them to overcome their current feelings of trepidation. Otherwise, many investors would instead just opt to go with longer-term bonds.
Determining an Inverted Spread
It is easy to determine the yield spread between two financial instruments, and then identify whether this is an inverted spread. You would calculate the spread difference using simple subtraction, given the yields of the two instruments involved.
For example, in the bond market, if you had a three-year government bond yielding 5 percent and a 30-year government bond yielding 3%, the spread between the two yields would be inverted by 2 percent, which you calculate by subtracting the 3 percent from 5 percent. The reasons behind this situation can vary and can include such things as changes in demand and supply of each instrument and the general economic conditions at the time.
Treasury note yields are often the most obvious, and the easiest to track and compare. You can very quickly contrast the yields of notes on the shorter end of the maturity spectrum, such as those with one-month, six-month or one-year terms, against those with terms of longer durations, such as 10-year bonds.